Is This Cheap Share Actually a Value Trap?

I started out as a “cigar butt” investor looking for low quality businesses which are so cheap that they are still worth investing in despite their less-than-desirable quality. This is similar to how one would hope to get one last “puff” from a cigar butt lying on the ground.

In Singapore’s current market environment, especially within the S-Chip sector (companies based in China but listed in Singapore), there are many cigar butts lying around. However, many of them may no longer have that last puff left in them. These shares – the ones without that last puff – are what’s commonly known as a value trap. These companies seem cheap but are actually cheap for a reason with no real catalyst to change the situation.

For a cigar-butt investor, the difficulty lies in deciding if a company is indeed a good cigar butt opportunity or just a value trap. And, Sunpower (SGX: 5GD) is actually an emblematic example.

At its current price of S$0.12 per share, Sunpower carries a trailing price to earnings (PE) ratio and price to book (PB) ratio of just 2.9 and 0.35, respectively. These are incredibly low valuations. For some perspective, the SPDR STI ETF (SGX: ES3), a proxy for Singapore’s market barometer the Straits Times Index (SGX: ^STI), carries a PE and PB ratio of 13.5 and 1.3.

Sunpower’s seemingly cheap valuation is made to look even cheaper when considering that the company had just recorded a 21.3% year-on-year increase in its revenue for the first half of 2014. Its net profit actually did even better, surging 82.6%.

Sunpower is involved with the engineering and fabrication of heat exchangers, pressure vessels, heat pipes, and heat pipe exchangers. The company serves a number of industries (including petrochemical, steel, and chemicals among others) and its products help clients save energy and improve their energy efficiency. According to the company’s presentation, it can enjoy tailwinds stemming from the Chinese government’s desire to move toward a more environmental friendly policy-stance.

But despite the positives, the company’s balance sheet is not in the best of shape. It has a net debt to equity ratio of 23% and its accounts receivable line item on the balance sheet is close to RMB1 billion, which is almost equivalent to Sunpower’s annual revenue.

Foolish Summary

Sunpower definitely has a great growth story going for it and some recent numbers to back it up. However, the reputation of S-chips in Singapore is so low that no matter how great their fundamentals seem to be, investors need to believe that the numbers are real before they can feel comfortable investing in such shares. With a PE ratio of less than 3, it seems that investors are still far from comfortable with Sunpower’s reported fundamentals.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.